DIVERSIFICATION

Diversification is the process of entering new business markets with new
products. Such efforts may be undertaken either through acquisitions or
through extension of the company's existing capabilities and
resources. The diversification process is an essential component in the
long range growth and success of most thriving companies, for it reflects
the fundamental reality of changing consumer tastes and evolving business
opportunity. But the act of diversifying requires significant outlays of
time and resources, making it a process that can make or break a company.
Small business owners, then, should carefully study diversification
options—and their own fundamental strengths—before
proceeding. "The range of success [of diversification efforts]
varies considerably," observed the editors of the
Complete MBA Companion.
"The odds of success decline precipitously the further the firm
strays from existing competencies."

Analysts of diversification generally break such efforts down into two
categories: 1) related or concentric diversification, and 2) unrelated or
conglomerate diversification. "In related diversification,"
wrote Henry Mintzberg and James Brian Quinn, authors of
The Strategy Process: Concepts and Contexts,
"there is evident potential synergy between the new business and
the core one, based on a common facility, asset, channel, skill, even
opportunity." But they also noted that "no matter what its
bases, every related diversification is also fundamentally an unrelated
one, as many diversifying organizations have discovered to their regret.
That is, no matter what
is
common between two different businesses, many other things are
not."

DIVERSIFICATION THROUGH ACQUISITION AND EXPANSION

Companies diversify either by acquiring already existing businesses or by
expanding their own businesses into new markets and new areas of
production or service. Acquisition is generally used more frequently by
big companies than smaller ones, since most acquisitions require a degree
of financial leverage and health that only larger firms can bring to bear.
Indeed, Mintzberg and Quinn remarked that "as organizations grow
large, they become inclined to diversify and then to divisionalize. One
reason is protection: large organizations tend to be risk
averse—they have too much to lose—and diversification
spreads the risk. Another is that as firms grow large, they come to
dominate their traditional market, and so must often find growth
opportunities elsewhere, through diversification. Moreover,
diversification feeds on itself. It creates a cadre of aggressive general
managers, each running his or her own division, who push for further
diversification and further growth. Thus, most of the giant corporations
… not only were able to reach their status by diversifying but also
feel great pressures to continue doing so."

Diversification through acquisition has its detractors.
"Acquisition has been criticized as sometimes stifling
innovation," noted the
Complete MBA Companion.
"A company deploys its resources to take over an existing business
rather than to pursue innovation." But the editors contend that
acquisition can actually liberate creativity if executed for the right
reasons: "If driven by visions of diversification, acquisition can
be an innovative impetus for that company in pursuing new opportunities
and moving in directions that might otherwise be blocked and which might
have greater incremental potential than its existing business
opportunities."

Diversification-by-expansion, on the other hand, is much more likely to be
utilized by small-and mid-sized companies. This strategy typically
requires smaller, though still significant, up-front financial
obligations, and generally involves moving into a market or
service/product with which the business already has at least some passing
acquaintance.

FACTORS TO CONSIDER WHEN WEIGHING DIVERSIFICATION

Although diversification into new markets and production areas can be an
exciting and profitable step for small business owners, consultants
caution them to "look before they leap." As entrepreneur
Steven L. Marks remarked in
Inc.,
when presented with opportunities to diversify, "we view them
against our focus criteria: Is the idea consistent with our mission
statement? Will it dilute our current efforts? How will it affect our
operations?" Indeed, many factors should be considered before a
small company launches a course of diversification:

FINANCIAL HEALTH
This is the most basic consideration of all. Business owners should
undertake a comprehensive and clinical review of their present fiscal
standing—and future prospects—before expanding a business
into a new area.

COST OF ENTRY
This factor is closely linked to a business's examination of its
fundamental financial health. Diversification, whether through expansion
or acquisition, typically requires financial outlays of significant size.
Does your company have the means to
meet those requirements while simultaneously keeping the existing
business running smoothly?

ATTRACTIVENESS OF THE INDUSTRY AND/OR MARKET
Analysts attach varying level of importance to this factor. Obviously,
diversification into an industry or market that is flagging, whether
because of general economic conditions or local problems, can result in a
significant loss of income and security. As Mintzberg and Quinn observed,
though, some businesses attach little significance to this, relying
instead on vague beliefs that the industry or market is a good fit with
its existing operations, or that the industry or market is headed for an
upturn. "Another common reason for ignoring the attractiveness test
is a low entry cost," they added. "Sometimes the buyer has
an inside track or the owner is anxious to sell. Even if the price is
actually low, however, a one-shot gain will not offset a perpetually poor
business." Finally, some businesses mistakenly interpret recent
market or industry trends as indications of long term health.

WORK FORCE RESOURCES
When considering diversification, companies need to analyze the ways in
which such a step could impact their current employee work forces. Are you
counting on some of those employees to take on added duties with little or
no change in their compensation? Will you ask any of your workers to
relocate their families or their place of work as a consequence of your
business expansion? Does your current work force possess the skills and
knowledge to handle the requirements of the new business, or will your
company need to initiate a concerted effort to attract new employees?
Business owners need to know the answers to such questions before
diversifying.

ACCESS TO DISTRIBUTION CHANNELS
A company engaged in introducing a new product or service into the
marketplace should first ensure that it will have adequate access to
distribution channels within the targeted market. "The more limited
the wholesale or retail channels for a product are and the more existing
competitors have these tied up, obviously the tougher entry into the
industry will be," wrote Michael E. Porter in
Competitive Strategy: Techniques for Analyzing Industries and
Competitors.
"Existing competitors may have ties with channels based on long
relationships, high-quality service, or even exclusive relationships in
which the channel is solely identified with a particular manufacturer.
Sometimes this barrier to entry is so high that to surmount it a new firm
must create an entirely new distribution channel."

REGULATORY ISSUES
Governmental regulatory policies at the local, state, and national level
can also have an impact on the diversification decision. For instance, a
successful restauranteur may want to open a bar and grille in a certain
area, only to learn that the city council has imposed an indefinite
moratorium on granting liquor licenses in the area in question.
"Government can limit or even foreclose entry into industries with
such controls as licensing requirements and limits on access to raw
materials," confirmed Porter, who added that regulatory controls on
air and water pollution standards and product safety and efficacy should
also be weighed. "For example, pollution control requirements can
increase the capital needed for entry and the required technological
sophistication and even the optimal scale of facilities. Standards for
product testing, common in industries like food and other health-related
products, can impose substantial lead times, which not only raise the
capital cost of entry but also give established firms ample notice of
impending entry and sometimes full knowledge of the new
competitor's product with which to formulate retaliatory
strategies." Many of these regulations, while enormously beneficial
to society, can have a bearing on the ultimate wisdom of a diversification
strategy.